In a post you wrote last year, you said “Let’s also assume that company did a financing and is worth $10.5m post-money (e.g. $3 / share), that the financing was done with preferred stock, and the board determined that the fair market value (FMV) for the common stock is $0.30 / share (common stock in a venture-backed company is often valued at 10% – 25% of the preferred – I’ll leave that for a separate post.)” Could you help explain the justification for the 10% – 25%?

A year ago when I wrote that post, I hadn’t thought much about the implication of the new IRS regulation 409A. While a draft had been published, it didn’t really catch the attention of the venture community until a critical memo was released in the fall. As a result, when I wrote the post in mid 2005, I was referring to a typical rule of thumb that VCs have been using since fire was invented to set the strike price for stock options.

The old rule of thumb was to price them at roughly 10% of the price of the preferred shares if the company was a very early stage company. As the company matured, the percentage would increase, usually slowly, and reach 25% of the current preferred price well before the company was profitable. In the days when software companies went public, the SEC looked back 18 months to determine “cheap stock issues” and – as long as the board was making an appropriate fair market value (FMV) assessment of the common stock and increasing it over time, with more significant increases occurring as the target date for the IPO drew nearer – all was probably ok (plus – the cheap stock charges were P&L accounting charges but were non cash charges so no one really struggled with them much anyway.) When the company went public, the stock would now have a market price that fluctuated regularly and stock options would be priced at whatever the stock traded with on the date of the grant.

This approach worked fine for a while. Serious lawyers would even encourage companies to price their options lower than a conservative board might suggest, as they were trained to use the 10% rule.

With the emergence of 409A, all of that went out the window. While the board still needs to determine the FMV of the common stock for purposes of pricing the stock option grant, the 10% rule no longer applies. Instead, a more rigorous analysis needs to take place. I’ve explained this extensively – with the help of my trusty sidekick Jason – in the 409A series on this blog.

Ironically, now that we’ve been living with 409A for a while, a bizarre unintended consequence has emerged. In order to comply with the 409A statute while being extra conservative, we have our companies hire an outside valuation expert to do a 409A valuation. In a number of cases, the FMV has come in at less than 10% of the preferred price (in one case it came in at under 5% of the preferred price.) Presumably, one of the goals of 409A was to increase the strike price on common stock as the premise was that many boards were setting FMV too low. Hah – be careful what you wish for.